Investor Corner/Building and judging a portfolio/Portfolio Construction & Behaviour
3.1.8 Rebalancing
Rebalancing brings a portfolio back to its target allocation by trimming assets that have grown beyond their target weight and adding to those that have fallen below it. It controls risk and enforces a disciplined process.
Why allocations drift on their own
If equity grows faster than debt over a year, an initial 60-40 equity-debt split can quietly drift to 70-30 without a single deliberate decision being made. This drift shifts the portfolio's actual risk level away from what was originally intended, purely as a side effect of different assets growing at different rates.
Rebalancing is the periodic adjustment of portfolio allocations back to their target percentages. If your target is 60% equity and 40% debt, and a strong equity rally has shifted the portfolio to 70% equity and 30% debt, rebalancing involves selling some equity and buying more debt to restore the 60/40 split. It is a disciplined, mechanical process that does not require a market view.
The effect of rebalancing is counter-intuitive: it systematically trims the asset class that has risen (selling high) and adds to the one that has fallen (buying low). This is the opposite of what most investors do instinctively (adding to winners, avoiding losers) and is precisely why it works. Over long periods, rebalancing has been shown to modestly improve risk-adjusted returns compared to a buy-and-hold approach, primarily by controlling risk rather than enhancing return.
What rebalancing actually does
Rebalancing means periodically selling a portion of whichever asset has grown to exceed its target weight, and using the proceeds to buy more of whichever asset has fallen below its target weight, restoring the intended mix. This mechanically enforces a version of selling relatively high and buying relatively low, without requiring any market prediction at all.
There are two common rebalancing approaches. Calendar rebalancing restores the target allocation at fixed intervals, typically annually or semi-annually. Threshold rebalancing triggers a rebalance only when any asset class drifts beyond a predefined band (for example, 5 percentage points from the target). Calendar rebalancing is simpler and requires no monitoring. Threshold rebalancing is more responsive but requires periodic checking. Both work. The important thing is to have a method and follow it consistently, not to optimise the method itself.
How often to actually do it
Rebalancing too frequently can generate unnecessary transaction costs and, outside tax-advantaged structures, unnecessary tax events. Common approaches rebalance either on a fixed schedule, such as annually, or whenever an allocation drifts beyond a set threshold, such as five percentage points from target, whichever comes first.
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Tax implications matter in India. Selling equity held for less than one year triggers short-term capital gains tax at 20%. Selling equity held for more than one year triggers LTCG at 12.5% above the annual exemption. For taxable accounts, the rebalancing trigger should be wide enough (annual frequency or 5%+ drift) that the tax cost of the trade does not exceed the risk reduction benefit. In tax-advantaged wrappers like NPS, rebalancing has no tax cost and can be done more frequently. New SIP contributions can also be directed toward the underweight asset class, achieving a partial rebalance without any selling.